How To Address Declining Front-End Margins

When we are no longer able to change a situation, we are challenged to change ourselves – Viktor Frankl

The news is full of major disruptors; if you follow the headlines you might think that a world filled with autonomous vehicles is imminent (it isn't), or that new owner and retail models will soon put dealers out of business (they won't).

However, there are changes happening in the auto industry that do impact retail auto sales, and that dealers should be worried about.

The most significant in my opinion is the long-established trend of eroding front-end margins. New vehicle gross margins have declined significantly in the last seven years, from 4.0% in 2011 to 2.2% in 2018.

In response to this challenge, many dealers have focused on growing F&I revenue to make up for lost profits. This worked for a while, but I don't this trend as sustainable. For one, we have maxed out what we can reasonably charge customers for F&I packages.

Additionally, the same transparency that drove down new-vehicle per vehicle retail (PVR) is likely to drive down F&I PVR. F&I gross margins are also vulnerable to rising interest rates and increased regulation.

These trends all point to a continued decline in front-end margins. Can anything be done? Well, you could take out some costs, but that comes with the risk of negatively impacting customer satisfaction. The second option is to create a more enduring relationship with your customers.

In business this is called a razor and razor-blade model. Manufacturers of razors and printers sell their product cheap, because the real money is made on the back end, by selling razor blades and ink cartridges.

For dealers, this means the majority of profits in the future will be made servicing vehicles. This requires a shift in operational mindset. If you can't make a killing off the first sale, how do you manage the customer relationship going forward?

The traditional dealership model is not well suited to this mindset. Dealerships were set up to optimize each transaction. Even the sale of the vehicle is split into two different transactions: the sale and F&I. On top of that, you try to sell a pre-paid maintenance contract, which three different departments need to get paid on. Additionally, dealerships set up compensation structures to encourage different departments to compete against each other.

The consumer only has one bucket of money. They don't have three buckets of money, and asking them to contribute to all your buckets is pushing the boundaries if your goal is to establish a meaningful and ongoing relationship.

More important, when you try to sell all of these things up front, you have just undermined the effort to maximize the value of that customer on the back end.

To successfully operate in a razor and razor-blade business environment, dealers might want to think about making some operational changes. Here are some recommendations:

Consolidate

For auto groups, consolidate back office functions such as accounting and HR. Stop thinking of your stores as individual entities and treat them as a chain with more consistency. It's easier to maintain brand identity for a single chain than half a dozen stores.

Get to a one-transaction sale

Merge the sales and F&I functions. Have a product presenter and a deal manager. The presenter demos the vehicle and takes customers on test drives. The deal manager coordinates final pricing and takes on the F&I role.

Be more transparent with vehicle and F&I pricing

Increased transparency is inevitable and embracing this fact sooner rather than later will help to cement customer relationships.

Partly due to regulations, the markup on loans is becoming more fixed and less negotiable. Dealers who are transparent on this markup don't have a problem getting a reasonable markup. Have you ever bought a house? The mortgage broker made a point on that loan. That was the fee for helping you find the right mortgage. If you try to get three points, that won't work for consumers. Be happy with one point, and the customer will be happy too.

Also start thinking about what you want your deal manager to sell. If you can make $300 on an etch or $300 on a service contract, which is more valuable to you? Putting etch on a car doesn't bring that car back to you.

Change Pay Plans

The original concept of sales commissions was based on the idea that the gross margin was determined by the strength of the sales manager and salesperson's ability to negotiate. Salespeople today really don't have the opportunity to influence gross margin, so why are we still paying them on that basis?

The same goes for service. An advisor presents the customer with a list of three repairs that need to be made. Instead, they should present one repair as urgent, one as cautionary and one that can be done down the road. But the advisor is afraid the customer won't be back or that if they do come back, they (the advisor) won't be the one to make commission off the sale. Is this putting your customers' best interest first?

Variable pay plans are out of alignment with an optimal customer experience. They encourage the wrong things, period.

Let's develop less mercenary pay plans. Pay someone a minimal salary so they are not dependent on individual transactions in order to put food on the table. Bonus on metrics other than gross sales, such as repeat business and positive reviews.

Shift Spend to Service Marketing

With the razor and razor-blade business model, everything in the dealership is geared towards driving customers to service. So why do auto dealers still place so much emphasis on marketing the sales side of their business? They argue that sales feeds service, but I would argue equally that service feeds sales.

When it comes to service marketing, dealers need to think outside the box. Move away from the oil change mentality and stop going after coupon chasers. You offer an entirely different experience that customers are willing to pay for; including expertise, OEM parts, nice amenities and facilities, loaner cars and peace of mind, especially on more expensive repairs.

If all of these changes seem overwhelming, take baby steps. But start now, because the dealers who learn how to operate a razor and razor-blade business model will still be around when the headline-grabbing disruptors materialize in a few years.

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